The Ultimate Causes of Risk Never Change

Nassim in some more focused presesntations before congress. Popout Comments on Stimulus and free markets: Popout Ht: Rocky Chen

Here is Rick Bookstabers' Testimony on VaR (pdf file), which is a very good introductory read.

My own opinion is that the best way to measure financial risk is to assume it is a function of concentration of opinion or belief. The more people, models, institutions etc. all believe the same thing to be true, the greater the risk.

There is no "truth" in finance; it is a social phenomenon. Unlike a physical reality like physics, the laws of economics are plastic. Homogeneity in opinion leads to homogeneity in action and reaction.

It isn't the models, ratings agencies, regulators, traders or banks that cause financial catastrophes, it is the fact that sometimes their opinions through mania, legislation or fate all converge leading to mania, panics and crashes.

Concentrations of opinion/belief are a form of collective myopia that is part of the human condition. We are social, we group, agree, act and propagate risk. The bubbles, actors and rationalizations change, but the ultimate causes of risk don't, we are all too human.

My own opinion is that the greatest current systemic risks outstanding are:

• The dollar as safe currency; for example, last year's lesson via the flight to quality leads to the maginot line behavior of today as the USD is now the darling of the carry trade.
• Basel II implementations leading to a "unified" framework for global banking risk.

Comments

[Mark Bern:]

Excellent post! Very refreshing points by Mr. Taleb.

Regarding the Basel Accords: We need to oppose anything that undermines our sovereignty. An the Basel Accords would do just that by placing international laws above national laws. Once that gate is opened, we begin to give up the right to self-govern. That is very dangerous. We fought a war once to gain our freedom from a monarch, to gain our personal freedoms, and to gain the right to govern our nation from within. We should not start down the path of giving up our hard-won independence.

Sep 21 09:08 AM

[User 353732:]

The ultimate causes of risk are the same in all times and places, it is true.
There are 2: when greed overrules prudence and when fear overrules courage. Unfortunately they manifestations of these risks are many and varied.
The typical investor cannot comprehend the limitless ways in which these risks mutate and appear. Moreover, there are few or no credible and enduring signs that let the typical investor know when greed is excessive or when fear is paramount in a specific market or asset class.
After all, the greedy investor(unless a privileged Wall St insider for whom greed is risk free these days) believes he or she is being courageous and the fearful investor(unless a Wall St insider for whom the Govt has abolished fear) believes that he or she is being prudent.

Sep 21 10:21 AM

[Mark Bern:]

Mr. Taleb has made some very important points that need to be addressed by our leaders in Washington, DC. Those that stand out for me are:
- The idea that "too big to fail" is just plain too big, period.
- Banks consistently loose all historical profits in one major event, over and over, and this risk can be regulated out of the industry by eliminating certain products that contain too much risk.
- We are not operating in a "free market" because in a free market society does not absorb the losses from failed companies; that should only happen in a socialist, centrally-controlled economy.
- The supposed "talent" on Wall Street is not really talented at anything but created huge bonuses for themselves. A group of people who lose $4.3 Trillion cannot be very talented.
- Default swaps he defined as akin to one person buying insurance on the Titanic from someone who is on the Titanic (excellent analogy).
- Finally, (and this, to me, may be the best one) that the bankruptcy system removes debt from society systematically when needed, while bailouts merely transfer responsibility for payment of the debt to society from failed institutions.

This last one really hits home. If we had allowed the auto companies, insurance companies, and big banks to fail we would have removed a great deal of debt from our economy. It would have been very painful in the short term, but our economy would already be very healthy again and able to recover with greater resilience. As it is, we have this huge debt load dragging the economy down for the next several decades, perhaps forever. Growth will be less robust than it could have been and those who caused the problem are still in control and heading us toward the next big bubble that will inevitably burst. And then, we will experience more pain, pass more debt to our children and grandchildren to line the pockets of the elites on Wall Street, and start the cycle all over again. Somehow, this has to stop! And the sooner the better, IMHO.

Sep 21 10:39 AM

[The Geoffster:]

It all comes down to trust and confidence. Are you more trustful and confident than you were one year ago?

Sep 21 01:07 PM

[David Van K...:]

"If we had allowed the auto companies, insurance companies, and big banks to fail we would have removed a great deal of debt from our economy. It would have been very painful in the short term, but our economy would already be very healthy again and able to recover with greater resilience."
-----
There is no credible foundation for this statement. The closest comparison may be what happened in the Depression, when banks and industries were allowed to fail. The economy did not get "very healthy again" for decades. It is easy to criticize what the government did when faced with the major banking crisis, and I am certainly not happy with everything they did. But to say that if they'd just done nothing, then everything would already be OK is to ignore what actually happened in the Depression. History rhymes.

Sep 22 02:15 PM